Felton reinhart (eds ) the first global financial crisis of the 21st century (2008)

The mortgage marketReminiscent of this pattern linking credit booms with banking crises, currentmortgage delinquencies in the US subprime mortgage market appear indeed to berelated to pa

The First Global Financial Crisis

of the 21st Century

A VoxEU.org Publication

Centre for Economic Policy Research (CEPR)

Centre for Economic Policy Research

53-56 Great Sutton Street

© June 2008 Centre for Economic Policy Research

British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British LibraryISBN: 978-0-9557009-3-4

Edited by Andrew Felton and Carmen Reinhart

The First Global Financial Crisis

of the 21st Century

A VoxEU.org Publication

Centre for Economic Policy Research (CEPR)

The Centre for Economic Policy Research is a network of over 700 Research Fellows andAffiliates, based primarily in European universities The Centre coordinates the researchactivities of its Fellows and Affiliates and communicates the results to the public and privatesectors CEPR is an entrepreneur, developing research initiatives with the producers,consumers and sponsors of research Established in 1983, CEPR is a European economicsresearch organization with uniquely wide-ranging scope and activities

The Centre is pluralist and non-partisan, bringing economic research to bear on the analysis

of medium- and long-run policy questions CEPR research may include views on policy, butthe Executive Committee of the Centre does not give prior review to its publications, andthe Centre takes no institutional policy positions The opinions expressed in this report arethose of the authors and not those of the Centre for Economic Policy Research

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in England (No 1727026)

Chair of the Board Guillermo de la Dehesa

President Richard Portes

Chief Executive Officer Stephen Yeo

Research Director Mathias Dewatripont

Policy Director Richard Baldwin

Preface ix

The relationship between the recent boom and the current 7 delinquencies in subprime mortgages

Giovanni Dell’Ariccia, Deniz Igan and Luc Laeven

Tito Boeri and Luigi Guiso

The impact of short-term interest rates on risk-taking: 41 hard evidence

Vasso P Ioannidou, Steven Ongena and Jose Luis Peydró

Guido Tabellini

Contents

The subprime crisis and credit risk transfer: 49 something amiss

frequently asked questions (updated)

Section 3 What Can Be Done? 119 The subprime crisis: Who pays and what needs fixing 121

Marco Onado

Alberto Giovannini and Luigi Spaventa

Can monetary policy really be used to stabilize asset prices? 163

Katrin Assenmacher-Wesche and Stefan Gerlach

Willem Buiter and Anne Sibert

The central bank as the market-maker of last resort: 171 from lender of last resort to market-maker of last resort

Willem Buiter and Anne Sibert

Luigi Spaventa

Contents vii

The subprime crisis, which boiled over in August 2007, was the perfect showcasefor Vox’s unique approach Mainstream media’s explanations of it as a liquiditycrisis did not seem to fit the facts How could a few deadbeat homeowners in theUnited States bring down a German Landesbank, force a restructuring on a majorFrench bank, and compel the Fed and the European Central Bank (ECB) to under-take emergency injections of cash? The story was surely deeper than a standard-issuecredit problem.

Starting on 13 August 2007, Vox posted a slew of columns by economists whoreally knew what they were talking about and were willing to explain the crisis interms that any trained economist could understand Mainstream media’s limits (800words written for the average newspaper reader) just did not work for an event ofthis complexity Vox provided commentators with the space to explain the situationusing standard economic terminology It raised the level of the public debate andthis attracted researchers who had also been at the cutting edge of policy-making,such as: Willem Buiter (professor at LSE and former member of the Bank ofEngland’s rate-setting Monetary Policy Committee), Steve Cecchetti (professor atBrandeis University and former Executive Vice President and Director of Research atthe New York Fed), Charles Wyplosz (professor at the Graduate Institute, Genevaand adviser to central banks), Marco Onado (professor at Bocconi and formerCommissioner of the Italian public authority responsible for regulating the Italiansecurities market, CONSOB), Tito Boeri (professor at Bocconi and editor of LaVoce)and Luigi Spaventa (professor in Rome and former Chairman of CONSOB)

On behalf of CEPR and the Vox editorial board, I would like to thank CarmenReinhart for agreeing to edit this compilation of columns Together with her col-league at the University of Maryland’s School of Public Policy, Andrew Felton, theresult is what follows, a primer on what is probably the worst financial crisis of ourgeneration

Richard Baldwin, VoxEU.org, Editor-in-Chief and CEPR Policy Director

June 2008

Preface

1

Global financial markets are showing strains on a scale and scope not witnessed inthe past three-quarters of a century What started with elevated losses on USsubprime mortgages has spread beyond the borders of the United States and theconfines of the mortgage market Risk spreads have ballooned, liquidity in somemarket segments has dried up and large complex financial institutions have admit-ted significant losses Bank runs are no longer the subject exclusively of history.These events have challenged policy-makers, and the responses have variedacross regions The ECB has injected reserves in unprecedented volumes The Bank

of England participated in the bailout and, ultimately, the nationalization of adepository, Northern Rock The US Federal Reserve has introduced a variety of newfacilities and extended its support beyond the depository sector

These events have also challenged economists to explain why the crisis oped, how it is unfolding, and what can be done This volume compiles contri-butions by leading economists in VoxEU over the past year that attempt to answerthese questions We have grouped these contributions into three sections corre-sponding to those three critical questions

devel-Why did the crisis happen?

The first set of articles contains reflections on the reasons for the crisis Although

it is tempting to suggest that the crisis was inevitable with hindsight, several cles emphasize the inherent uncertainty of economic analysis Dell’Ariccia, Iganand Laeven discuss the role of uncertainty in the subprime lending boom Persaudand Danielsson both caution against the overreliance on standardized quantita-tive risk models Finally, Wyplosz counsels prudence when analysing the crisis andits causes in the face of high uncertainty

arti-Several articles search for the roots of the crisis in public policy, either tary or regulatory Cecchetti has a series of ‘Frequently Asked Questions’ about theextraordinary monetary policy actions taken to alleviate the crisis He argues thatcrises are endemic to modern economies and should not necessarily be blamed onmonetary policy A well-functioning financial system needs both deposit insur-ance and a central bank with regulatory authority, he says Boeri and Guiso dis-agree, blaming the crisis on low US interest rates Ioannidou et al avoid directlyblaming the Federal Reserve for the crisis but present empirical evidence that low

mone-interest rates, like those present in the United States in 2003 and 2004, encourageex-ante risk-taking.

Other articles focus on the regulatory system Tabellini blames some of theproblem on the fragmented nature of the US regulatory system Spaventa focuses

on the growth of off-balance sheet banking activity and argued that regulatorsboth missed the explosive growth of financing mechanisms like structured invest-ment vehicles (SIVs) and failed to see the hidden risks to the banking system thatthese unconventional instruments created

Several authors reach beyond the recent past to understand the present Bordo,starting from 1921, finds that turning points in the credit cycle often correspond

to turning points in the business cycle as well Reinhart reviews five major cial crises in industrial economies and concludes that the current economic prob-lems have a great deal of precedent

finan-How is the crisis unfolding?

The next section consists of articles discussing the events as they unfolded As thecrisis opened in late summer 2007, economists disagreed on its likely magnitude

It initially appeared to be a simple liquidity problem The Federal Reserve duced a number of novel policy responses in its role as lender of last resort role,detailed in a continuation of Cecchetti’s FAQ series These policies included thelargest single cut in the federal funds target rate since the early 1980s, currencyswaps with foreign central banks, and three new lending mechanisms, the termauction facility, the term securities lending facility, and the primary dealer creditfacility Monacelli thinks that the liquidity problems are ‘extensive but benign’.Calomiris contends that ‘there is little reason to believe that a substantial decline

intro-in credit supply under the current circumstances will magnify the shocks and turnthem into a recession’ Buiter judges the Federal Reserve’s first rate cut inSeptember 2007 unnecessary, because of the fiscal policy response under way Buiter also cautions everyone to remember the difference between inside assets,which are a zero-sum game that just transfer money between parties, and outsideassets, which are real assets that lack an offsetting liability Vives suggests that theproblems in modern markets such as asset-backed commercial paper, auction-ratesecurities, etc., directly parallel and require the same response as an old-fashionedbanking crisis, namely the central bank should lend freely against good collateral

at penalty rates (as Bagehot’s classic wisdom suggests)

However, Ubide presciently spells out a variety of reasons why what appeared

at first to be a simple liquidity problem masked far deeper credit pathologies.Snower tries to anticipate some of the possible international spillover effects fromthe US problems In another article, Snower outlines four mega-dangers to thefinancial system and suggests that our surprise at continued crises is more sur-prising than the crises themselves

The section ends with another article by Cecchetti that summarizes the FederalReserve’s reactions to date Wyplosz admires the Fed’s innovation and speed, con-trasting it to the more cautious ECB

2 The First Global Financial Crisis of the 21st Century

Introduction 3

What can be done?

VoxEU.org has published several articles with policy suggestions to prevent thiskind of crisis from happening again One major theme was enhancing informationdissemination In August, Onado focused on three aspects that later commenta-tors would return to: credit ratings, evaluations of asset marketability and trans-parency in the retail market for financial assets Giovannini and Spaventa urgegreater dissemination of information and rethinking of the Basel II accord onbank capital requirements

Buiter contributes a series of articles on the policy lessons from the UnitedKingdom’s Northern Rock debacle He blames both policies and institutionalarrangements, including an ineffective deposit-insurance scheme, poor regulatorycoordination and division of responsibilities, and weaknesses of the supervisorystandards embodied in Basel II

Portes writes on regulatory reform, covering ratings agencies, sovereign wealthfunds and financial institutions De la Dehesa urges more regulation of mortgagebrokers, greater transparency and methods to overcome banks’ principal–agentproblems Persaud says that regulators need to accept that the commoditization oflending means that instability is built into the financial system and regulatorsneed to proactively pursue counter-cyclical policies

The future of monetary policy and central banking is also a recurring theme

De Grauwe contends that inflation targeting restricts banks’ ability to restrainasset bubbles, while Assenmacher-Wesche and Gerlach warn against trying to usecentral-bank policy to stabilize asset prices Buiter and Sibert advocate the expand-

ed use of liquidity policies rather than monetary easing They think that centralbanks should act as the market-maker of last resort Spaventa proposes that thegovernment should purchase illiquid securities, likening his proposal to the BradyPlan that unfroze the Latin American debt markets in 1989

Section 1

Why Did the Crisis Happen?

4 February 2008

Recent US mortgage market troubles unsteadied the global economy This article summarizes research analysing millions of loan applications to investigate the roots of the crisis A credit boom may be to blame.

Recent events in the market for mortgage-backed securities have placed the USsubprime mortgage industry in the spotlight Over the last decade, this market hasexpanded dramatically, evolving from a small niche segment into a major portion

of the overall US mortgage market Can the recent market turmoil – triggered bythe sharp increase in delinquency rates – be related to this rapid expansion? Inother words, is the recent experience, in part, the result of a credit boom gonebad? While many would say yes to these questions, rigorous empirical evidence

on the matter has thus far been lacking

Credit booms

There appears to be widespread agreement that periods of rapid credit growth tend

to be accompanied by loosening lending standards For instance, in a speech ered before the Independent Community Bankers of America on 7 March 2001,the then Federal Reserve chairman, Alan Greenspan, pointed to ‘an unfortunatetendency’ among bankers to lend aggressively at the peak of a cycle and arguedthat most bad loans were made through this aggressive type of lending

deliv-Indeed, most major banking crises in the past 25 years have occurred in thewake of periods of extremely fast credit growth Yet not all credit booms arefollowed by banking crises Indeed, most studies find that, while the probability

of a banking crisis increases significantly (by 50–75%) during booms, historicallyonly about 20% of boom episodes have ended in a crisis For example, out of 135credit booms identified in Barajas et al (2007) only 23 preceded systemic bankingcrises (about 17%), with that proportion rising to 31 (about 23%) if non-systemicepisodes of financial distress are included In contrast, about half of the bankingcrises in their sample were preceded by lending booms Not surprisingly, larger andlonger-lasting booms, and those coinciding with higher inflation and – to a lesserextent – lower growth, are more likely to end in a crisis Booms associated with fast-rising asset prices and real-estate prices are also more likely to end in crises

The relationship between the recent boom and the current delinquencies

in subprime mortgages

Giovanni Dell’Ariccia, Deniz Igan and Luc Laeven

IMF; IMF; IMF and CEPR

7

The mortgage market

Reminiscent of this pattern linking credit booms with banking crises, currentmortgage delinquencies in the US subprime mortgage market appear indeed to berelated to past credit growth (Figure 1) In a new working paper, we analyse datafrom over 50 million individual loan applications and find that delinquency ratesrose more sharply in areas that experienced larger increases in the number andvolume of originated loans (Dell’Ariccia et al., 2008) This relationship is linked to

a decrease in lending standards, as measured by a significant increase in income ratios and a decline in denial rates, not explained by improvement in theunderlying economic fundamentals

loan-to-In turn, the deterioration in lending standards can be linked to five main factors.Standards tended to decline more where the credit boom was larger This is con-sistent with cross-country evidence on aggregate credit booms

Lower standards were associated with a fast rate of house price appreciation,consistent with the notion that lenders were to some extent gambling on acontinuing housing boom, relying on the fact that borrowers in default couldalways liquidate the collateral and repay the loan

Changes in market structure mattered: lending standards declined more in regionswhere large (and aggressive) previously absent institutions entered the market.The increasing recourse by banks to loan sales and asset securitization appears

to have affected lender behaviour, with lending standards experiencing greaterdeclines in areas where lenders sold a larger proportion of originated loans.Easy monetary conditions seem to have played a role, with the cycle in lendingstandards mimicking that of the Federal Fund rate In the subprime mortgagemarket most of these effects appear to be stronger and more significant than inthe prime mortgage market, where loan denial decisions seem to be more closelyrelated to economic fundamentals

8 The First Global Financial Crisis of the 21st Century

Growth of Loan Origination Volume 2000–2004 (in percent)

Figure 1 A credit boom gone bad?

These findings are consistent with the notion that rapid credit growth episodes,due to the cyclicality of lending standards, might create vulnerabilities in thefinancial system The subprime experience demonstrates that even highly-devel-oped financial markets are not immune to problems associated with credit booms.

Possible solutions

What can be done to curb bad credit booms? Historically, the effectiveness ofmacroeconomic polices in reducing credit growth has varied (see, for example,Enoch and Ötker-Robe, 2007) While monetary tightening can reduce both thedemand and supply of bank loans, its effectiveness is often limited by capital-account openness This is especially the case in small open economies and incountries with more advanced financial sectors, where banks have easy access toforeign credit, including from parent institutions Monetary tightening may alsolead to significant substitution between domestic and foreign-denominated credit,especially in countries with (perceived) rigid exchange-rate regimes Fiscal tight-ening may also help reduce the expansionary pressures associated with creditbooms, though this is often not politically feasible

While prudential and supervision policies alone may prove not very effective incurbing credit growth, they may be very effective in reducing the risks associatedwith a boom Such policies include prudential measures to ensure that banks andsupervisors are equipped to deal with enhanced credit risk (such as higher capitaland provisioning requirements, more intensive surveillance of potential problembanks and appropriate disclosure requirements of banks’ risk management poli-cies) Prudential measures may also target specific sources of risks (such as limits

on sectoral loan concentration, tighter eligibility and collateral requirements forcertain categories of loans, limits on foreign-exchange exposure and maturity mis-match regulations) Other measures may aim at reducing existing distortions andlimiting the incentives for excessive borrowing and lending (such as the elimina-tion of implicit guarantees or fiscal incentives for particular types of loans, andpublic risk awareness campaigns)

In response to aggressive lending practices by mortgage lenders, several states

in the United States have enacted anti-predatory lending laws By the end of 2004,

at least 23 states had enacted predatory lending laws that regulated the provision

of high-risk mortgages However, research shows that these laws have not beeneffective in limiting the growth of such mortgages, at least in the United States(see, for example, Ho and Pennington-Cross, 2007) At the end of 2006, US feder-

al banking agencies issued two guidelines out of concern that financial tions had become overexposed to the real-estate sector while lending standardsand risk management practices had been deteriorating, but these guidelines weretoo little, too late

increasingly large share of the overall mortgage market, has thus far avoided asurge in delinquencies of such mortgages (though in September 2007, the US sub-prime crisis indirectly did lead to liquidity problems and eventually a bank run ondeposits at Northern Rock, the United Kingdom’s fifth-largest mortgage lender atthe time) Regulatory action on the part of the UK Financial Services Authority,resulting in the 2004 Regulation on Mortgages, which made mortgage lendingmore prescriptive and transparent in the UK, may have played a role Of course,only time will tell how successful these actions have been We would not be sur-prised to learn that lending standards have also deteriorated in mortgage marketsoutside the United States.

References

Barajas, Adolfo, Giovanni Dell’Ariccia and Andrei Levchenko (2007), ‘CreditBooms: The Good, the Bad, and the Ugly’, unpublished manuscript,Washington, DC: International Monetary Fund

Dell’Ariccia, Giovanni, Deniz Igan and Luc Laeven (2008), ‘Credit Booms andLending Standards: Evidence from the Subprime Mortgage Market’, CEPRDiscussion Paper No 6683, London: CEPR

Enoch, Charles and Inci Ötker-Robe, eds (2007), Rapid Credit Growth in Central

and Eastern Europe: Endless Boom or Early Warning?, Washington, DC:

International Monetary Fund and New York: Palgrave MacMillan

Ho, Giang and Anthony Pennington-Cross (2007), ‘The Varying Effects of

Predatory Lending Laws on High-Cost Mortgage Applications’, Federal Reserve

Bank of St Louis Review 89 (1), pp 39–59.

Note: This article refers to CEPR Discussion Paper DP6683

10 The First Global Financial Crisis of the 21st Century

4 April 2008

Financial supervision arguably failed to prevent today’s turmoil because it relied upon the very price-sensitive risk models that produced the crisis This article calls for an ambitious departure from trends in modern financial regulation to correct the problem.

Greenspan and others have questioned why risk models, which are at the centre

of financial supervision, failed to avoid or mitigate today’s financial turmoil Thereare two answers to this, one technical and the other philosophical Neither is com-plex, but many regulators and central bankers chose to ignore them both.The technical explanation is that the market-sensitive risk models used bythousands of market participants work on the assumption that each user is the onlyperson using them This was not a bad approximation in 1952, when the intellec-tual underpinnings of these models were being developed at the Rand Corporation

by Harry Markovitz and George Dantzig This was a time of capital controls betweencountries, the segmentation of domestic financial markets and – to get the histori-cal frame right – it was the time of the Morris Minor with its top speed of 59mph

In today’s flat world, market participants from Argentina to New Zealand havethe same data on the risk, returns and correlation of financial instruments, anduse standard optimization models, which throw up the same portfolios to befavoured and those not to be Market participants do not stare helplessly at theseresults They move into the favoured markets and out of the unfavoured.Enormous cross-border capital flows are unleashed But under the weight of theherd, favoured instruments cannot remain undervalued, uncorrelated and low-risk They are transformed into the precise opposite

When a market participant’s risk model detects a rise in risk in his or her folio, perhaps because of some random rise in volatility, and he or she tries toreduce his exposure, many others are trying to do the same thing at the same timewith the same assets A vicious cycle ensues as vertical price falls, promptingfurther selling Liquidity vanishes down a black hole The degree to which thisoccurs has less to do with the precise financial instruments and more with thedepth of diversity of investors’ behaviour Paradoxically, the observation of areas

port-of safety in risk models creates risks, and the observation port-of risk creates safety.Quantum physicists will note a parallel with Heisenberg’s uncertainty principle

Why bank risk models failed

Avinash Persaud

Intelligence Capital

11

Policy-makers cannot claim to be surprised by all of this The observation thatmarket-sensitive risk models, increasingly integrated into financial supervision in

a prescriptive manner, were going to send the herd off the cliff edge was madesoon after the last round of crises.1Many policy officials in charge today respondedthen that these warnings were too extreme to be considered realistic

The reliance on risk models to protect us from crisis was always foolhardy Interms of solutions, there is only space to observe that if we rely on market prices

in our risk models and in value accounting, we must do so on the understandingthat in rowdy times central banks will have to become buyers of last resort of dis-tressed assets to avoid systemic collapse This is the approach upon which we havestumbled Central bankers now consider mortgage-backed securities as collateralfor their loans to banks But the asymmetry of being a buyer of last resort withoutalso being a seller of last resort during the unsustainable boom will only condemn

12 The First Global Financial Crisis of the 21st Century

1 Avinash Persaud (2000), ‘Sending the Herd off the Cliff Edge: the Disturbing Interaction between Herding and Market-sensitive Risk Management Models’, Jacques de Larosiere Prize Essay, Institute of International Finance, Washington, DC.

8 May 2008

In response to financial turmoil, supervisors are demanding more risk tions But model-driven mispricing produced the crisis, and risk models do not perform during crisis conditions The belief that a really complicated statistical model must be right is merely foolish sophistication.

calcula-A well-known US economist, drafted during the second world war to work in the USArmy meteorological service in England, got a phone call from a general in May 1944asking for the weather forecast for Normandy in early June The economist repliedthat it was impossible to forecast weather that far into the future The general whole-heartedly agreed but nevertheless needed the number now for planning purposes.Similar logic lies at the heart of the current crisis

Statistical modelling increasingly drives decision-making in the financial system,while at the same time significant questions remain about model reliability andwhether market participants trust these models If we ask practitioners, regulators

or academics what they think of the quality of the statistical models underpinningpricing and risk analysis, their response is frequently negative At the same time,many of these same individuals have no qualms about an ever-increasing use ofmodels, not only for internal risk control but especially for the assessment of sys-temic risk and therefore the regulation of financial institutions.1To have numbersseems to be more important than whether the numbers are reliable This is a para-dox How can we simultaneously mistrust models and advocate their use?

What’s in a rating?

Understanding this paradox helps understand both how the crisis came about andthe frequently inappropriate responses to the crisis At the heart of the crisis is thequality of ratings on SIVs These ratings are generated by highly sophisticated sta-tistical models

Subprime mortgages have generated most headlines That is of course simplistic

A single asset class worth only $400 billion should not be able to cause such turmoil

Blame the models

And indeed, the problem lies elsewhere, with how financial institutions packagedsubprime loans into SIVs and conduits and the low quality of their ratings.

The main problem with the ratings of SIVs was the incorrect risk assessmentprovided by rating agencies, who underestimated the default correlation in mort-gages by assuming that mortgage defaults are fairly independent events Of course,

at the height of the business cycle that may be true, but even a cursory glance athistory reveals that mortgage defaults become highly correlated in downturns.Unfortunately, the data samples used to rate SIVs often were not long enough toinclude a recession

Ultimately this implies that the quality of SIV ratings left something to bedesired However, the rating agencies have an 80-year history of evaluating cor-porate obligations, which does give us a benchmark to assess the ratings quality.Unfortunately, the quality of SIV ratings differs from the quality of ratings of reg-ular corporations A AAA for a SIV is not the same as a AAA for Microsoft.And the market was not fooled After all, why would a AAA-rated SIV earn 200basis points above a AAA-rated corporate bond? One cannot escape the feelingthat many players understood what was going on but happily went along Thepension fund manager buying such SIVs may have been incompetent, but he orshe was more likely simply bypassing restrictions on buying high-risk assets

meas-to day, when everything is calm, we can ignore endogenous risk In crisis, we not And that is when the models fail

can-This does not mean that models are without merits On the contrary, they have

a valuable use in the internal risk management processes of financial institutions,where the focus is on relatively frequent small events The reliability of modelsdesigned for such purposes is readily assessed by a technique called backtesting,which is fundamental to the risk management process and is a key component inthe Basel Accords

Most models used to assess the probability of small frequent events can also beused to forecast the probability of large infrequent events However, such extrap-olation is inappropriate Not only are the models calibrated and tested with par-ticular events in mind, but it is impossible to tailor model quality to large infre-quent events or to assess the quality of such forecasts

14 The First Global Financial Crisis of the 21st Century

Taken to the extreme, I have seen banks required to calculate the risk of

annu-al losses once every thousand years, the so-cannu-alled 99.9% annuannu-al losses However,the fact that we can get such numbers does not mean the numbers mean any-thing The problem is that we cannot backtest at such extreme frequencies Similararguments apply to many other calculations, such as expected shortfall or tailvalue-at-risk Fundamental to the scientific process is verification, in our casebacktesting Neither the 99.9% models nor most tail value-at-risk models can bebacktested, and therefore cannot be considered scientific

Demanding numbers

We do, however, see increasing demands from supervisors for exactly the tion of such numbers as a response to the crisis Of course the underlying moti-vation is the worthwhile goal of trying to quantify financial stability and systemicrisk However, exploiting the banks’ internal models for this purpose is not theright way to do it The internal models were not designed with this in mind and

calcula-to do this calculation is a drain on the banks’ risk management resources It is thelazy way out If we do not understand how the system works, generating numbersmay give us comfort But the numbers do not imply understanding

Indeed, the current crisis took everybody by surprise in spite of all the ticated models, all the stress testing and all the numbers I think the primarylesson from the crisis is that the financial institutions that had a good handle onliquidity risk management came out best It was management and internalprocesses that mattered – not model quality Indeed, the problem created by theconduits cannot be solved by models, but the problem could have been prevent-

sophis-ed by better management and especially better regulations

With these facts increasingly understood, it is incomprehensible to me whysupervisors are increasingly advocating the use of models in assessing the risk ofindividual institutions and financial stability If model-driven mispricing enabledthe crisis to happen, what makes us believe that future models will be any better?Therefore one of the most important lessons from the crisis has been the expo-sure of the unreliability of models and the importance of management The viewfrequently expressed by supervisors that the solution to a problem like thesubprime crisis is Basel II is not really true The reason is that Basel II is based onmodelling What is missing is for the supervisors and the central banks to under-stand the products being traded in the markets and have an idea of the magnitude,potential for systemic risk and interactions between institutions and endogenousrisk, coupled with a willingness to act when necessary In this crisis the keyproblem lies with bank supervision and central banking, as well as with the banksthemselves

Reference

Danielsson, Jon (2002), ‘The Emperor has No Clothes: Limits to Risk Modelling’,

Journal of Banking and Finance 26 (7), pp 1273–96.

Blame the models 15

16 August 2007

A basic principle of high uncertainty is to be careful This principle also applies to analyses of the situation, even if decisiveness in the face of turmoil is at a premium Better wait than make things worse Here are a few observations to sort through the emerging debate.

As financial anxiety keeps mounting worldwide, comments flourish and joyfullycontradict each other Central banks are bailing out dangerous gamblers, says one.They are skilfully preventing a 1929-style crash, says another one Things arebeing gradually normalized, some assert This is just the beginning of a viciouscircle of unforeseen meltdown, just wait, warn others

One thing all agree about is that uncertainty, which market participants withshort memories – many of whom were teenagers or unborn the last big timearound – thought was a thing of the past, has made a striking comeback.Uncertainty did not just hit markets all over the world, it is affecting our under-standing as well, hence the wide disparity of opinions A basic principle of highuncertainty is to be careful This principle also applies to analyses of the situation,even if decisiveness in the face of turmoil is at a premium Better wait than makethings worse Here are a few observations to sort through the emerging debate.The origin of the problem is pretty well understood and adequately described

in Stephen Cecchetti’s 15 August 2007 Vox column ‘Federal Reserve policy actions

in August 2007: frequently asked questions’ As the US housing bubble is workingits way out, mortgaged loans go sour Since the institutions that granted theseloans have promptly sold them on – this is the securitization process – to otherinstitutions, which sold them on to others, and so on again and again, those whosuffer losses are the ultimate holders There are so many of them, all over theworld, that no one knows where the losses are being borne It could even be you,through your pension fund or some innocuous-looking investment

The second observation that all agree about is that the total size of the nowinfamous subprime loans, even augmented by normal mortgages, does not add up

to a huge amount Normally, most financial institutions should be able to absorbthem with much damage Of course, a few may have bought too much of the stuffand they will go belly-up, but that is how things normally are Most significantfinancial institutions should be able to absorb those particular losses

The subprime crisis: observations on the emerging debate

Charles Wyplosz

Graduate Institute, Geneva and CEPR

17

Here comes the securitization story, and it is not controversial either The tion of risk is a good thing, no doubt about it But it is generally the case that anygood thing has some drawback In this case the drawback is that no one knowswho holds how much of these bad loans Where things got bad is that, the same

dilu-as many other human beings, and maybe a little more so, financiers are prone tomood swings When all was going well, they trusted each other as if they had gone

to the same schools, which in fact they did When the situation soured, they went

at light speed to the other corner and started to suspect that everyone else wasmore in trouble, especially those they knew best because they went to schooltogether So the interbank market froze

This is where disagreements emerge Did the central banks do the right thing?Some observers lament that they should act as lenders of last resort, which meansintervening sparingly at punishing cost The problem with that view is that centralbanks did not intervene as lenders of last resort All central banks have the respon-sibility of assuring the orderly functioning of the financial markets The interbankmarket is the mother of all financial markets, and it was drying up So the centralbanks had no choice but to restart the interbank markets In addition, moderncentral banks operate by announcing an interest rate, the interbank rate If they

do not enforce that rate, they destroy their own chosen strategy, which has servedthem well so far This strategy allows them to change the interbank rate any timethey wish But until they do so, they have no choice but to make that rate stick

As for punishment, who were they supposed to punish? Not a particular bank, thistime The market, then? Collective punishment is generally a bad idea In thiscase, it would be a terrible idea If central banks punish the interbank market, theypunish all financial markets, and therefore they punish all those who depend onthese markets, which means almost all of humanity Even Castro and Kim Jong Il.The next big disagreement is whether things will become worse It is easy tobuild scenarios that lead to disaster Many excellent stories circulate and, like anygood horror stories, they ring true They usually describe hedge funds with seriousexposure to subprime loans as quickly trying to restore solvency by selling theirbest assets, pushing their value down Even hedge funds that are not exposed tobad loans may be fighting for their lives if their clients withdraw funds, eitherbecause they are worried or because they must, given their own regulations orrules Rating agencies are then forced to downgrade loads of assets and fundswhose fundamentals are perfectly safe, simply because they are being downloaded

on the market At that stage, 1929 starts looking heavenly in comparison withwhat happens next Well, that could be what is in store But note that it does nothave to be so

Remember first that, on its own, the mortgage crisis is small beer Recall nextthat most serious financial institutions must have made adequate provisions toface this long-expected crisis; some call it normalization Note that the large cen-tral banks have shown that they have learnt the lesson from past crisis and quicklymoved to provide the interbank markets with the required liquidity The situation

is basically sound But financial markets are always subject to self-fulfillingprophecies: if they believe that things will go wrong, things go wrong That iswhere we stand now

Isn’t it very frustrating to find ourselves, once again, on the verge of disasterand realize that our well-being depends on the whims of a few financiers not

18 The First Global Financial Crisis of the 21st Century

particularly known for being sedate? Why can’t we prevent this once and for all?The sad thing is that armies of regulators and supervisors have been doing justthat for years and years Remember Basel II, meant to be even better than Basel I?Nowadays banks are so tightly regulated that it is almost not fun any more to be

a banker Well, almost Banking is about lending, and lending is risky In addition,

as we all know, high risk means high (expected) return Naturally, bankers haveresponded to regulation by carrying on with lending, risky and not risky, but theyhave been subcontracting the risk that they are not supposed to hold The greatsecuritization wave is partly a consequence of the great regulation operation.The deeper moral is simple Financial markets exist to do risky things The morerisk they take, the higher the (expected) returns You can use regulation to squeezerisk out of a segment of the market, say banks, but you do not eliminate the risk,you just move it elsewhere New segments, say hedge funds, emerge to take overthe risk and the high (expected) returns that go with it The problem is that little

is known of the new segment and its players, so the armies of regulators and visors that protect us look in the wrong direction because they do not know where

super-to look There has been much talk about regulating the hedge funds; it mighthappen, so the game will move elsewhere The only way to eliminate financialcrises is to fully eliminate risk Kim Jong Il knows how: eliminate financial insti-tutions But that means no (expected) returns

The subprime crisis: observations on the emerging debate 19

26 November 2007

This is the first in a series of four essays exploring the lessons from the subprime turmoil It sets the stage for the series, arguing that financial crises are intrinsic to the modern economy, but both individuals and governments should make adjustments

to reduce the frequency of financial crises and their impact on the broader economy.

While the crisis may not be over, we can still pause and take stock What lessonsshould we take away from the turmoil that began in early August 2007? Most ofwhat I will discuss is not new But recent events have brought some importantissues into better focus Reflecting on the central causes of the problems we cur-rently face leads me to conclude: there will always be a next crisis

Its centrality to industrial economic activity, combined with a potential forabuse, has made the financial system one of the most heavily regulated parts ofour economy Through a variety of regulators and supervisors with overlappingresponsibilities, governments make voluminous rules and then set out to enforcethem The idea of a laissez-faire financial system makes no sense even to mostardent champions of the free market

Even with intense oversight by the governmental authorities – in the UnitedStates we have the Office of the Comptroller of the Currency, the Federal DepositInsurance Corporation and the Federal Reserve, as well as state banking authori-ties – crises continue to come One reason for this is the natural tendency ofofficials to fight the last battle, looking for systemic weaknesses revealed by themost recent crisis So, when complex automated trading schemes were thought tohave contributed to the October 1987 stockmarket crash, circuit breakers were put

in place that shut down computer-based order systems when indices move bymore than a certain amount In the aftermath of the Asian crisis, the IMF creatednew lending facilities in an attempt to address issues of contagion – in essence, todeal with countries that were innocent victims of problems created elsewhere.And when LTCM collapsed there was a flurry of activity to understand the poten-tial impact of what were called highly leveraged institutions

As necessary as each of these reforms may have been, we are not going to stoptomorrow’s crises by looking backwards Financial innovators will always seek outthe weakest point in the system Innovations will both exploit flaws in the regu-latory and supervisory apparatus and manipulate the inherent limitations of the

The subprime series, part 1:

Financial crises are not going away

Stephen G Cecchetti

Bank for International Settlements and CEPR

21

relationship between asset managers and their investor clients The 2007 crisisprovides examples of both of these Let us look at each in turn.

Innovations exploited flaws in the regulatory and supervisory apparatus

Financial institutions have been allowed to reduce the capital that they hold byshifting assets to various legal entities that they do not own, what we now refer to

as conduits and SIVs (Every financial crisis seems to come with a new vocabulary.)Instead of owning the assets, which would have attracted a capital charge, thebanks issued various guarantees to the SIVs, guarantees that did not require thebanks to hold capital

The purpose of a financial institution’s capital is to act as insurance againstdrops in the value of its assets The idea is that even if some portion of a bank’sloan portfolio goes bad, there will still be sufficient resources to pay off depositors.Since capital is expensive, bank owners and managers are always on the lookoutfor ways to reduce the amount they have to hold It is important to keep in mindthat under any system of rules, clever (and very highly paid) bankers will alwaysdevelop strategies for holding the risks that they want as cheaply as they can,thereby minimizing their capital

Manipulation of the asset manager–client relationship

But this is not the only problem Financial innovators will also seek ways in which

to exploit the relationship between the ultimate investor (the principal) and themanagers of the investor’s assets (the agent) The problem is that the agent actsprimarily in his or her personal interest, which may or may not be the same as theinterest of the principal The principal–agent problem is impossible to escape.Think about the manager of a pension fund who is looking for a place to putsome cash

Rules, both governmental and institutional, restrict the choices to high-ratedfixed-income securities The manager finds some AAA-rated bond that has a slightlyhigher yield than the rest Because of differences in liquidity risk, for example, onebond might have a yield that is 20 or 30 basis points (0.20 or 0.30 percentagepoints) higher Looking at this higher-yielding option, the pension-fund managernotices that there is a very slightly higher probability of a loss But, on closerexamination, he sees that this higher-yielding bond will only start experiencingdifficulties if there is a system-wide catastrophe Knowing that in the event ofcrisis, he will have bigger problems than just this one bond, the manager buys it,thereby beating the benchmark against which his performance is measured I submitthat there is no way to stop this Managers of financial institutions will alwayssearch for the boundaries defined by the regulatory apparatus, and they will findthem After all, detailed regulations are a guide for how to legally avoid the spirit

of the law And the more detailed the rules, the more ingenious the avoidance.This brand of ingenuity is very highly rewarded, so I am sure these strategies willcontinue

22 The First Global Financial Crisis of the 21st Century

So, what to do? Both individuals and government officials need to make ments Individual investors need to demand more information and they need toget it in a digestible form As individuals we should adhere to the same principlethat President Ronald Reagan followed in agreements over nuclear weapons withthe Soviet Union: trust, but verify We should insist that asset managers andunderwriters start by disclosing the detailed characteristics of what they are sell-ing together with their costs and fees This will allow us to know what we buy, aswell as understand the incentives that our bankers face

adjust-As for government officials, most of the lessons point to clarifying the relativeriskiness associated with various parts of the financial system Elsewhere I havesuggested that at least some of the problems revealed by the current crisis can beameliorated by increasing the standardization of securities and encouraging trad-ing to migrate to organized exchanges

Next articles

In the next essays in this series I will continue along this theme Part 2 discussesthe lesson I have taken away from the Bank of England’s recent experience: that alender of last resort is no substitute for deposit insurance In part 3, I addresswhether central banks should have a direct role in financial supervision, conclud-ing that they should And finally, in part 4, I examine whether central banks’actions have created moral hazard, encouraging asset managers to take on morerisk than is in society’s interest My answer is no

Notes: Deposit insurance has a dramatic impact on the amount of capital a bank holds With deposit insurance, depositors do not care about the assets on their bank’s balance sheet And without supervision from their liability holders (the depositors) there is a natural tendency to increase the risk that they take The bank’s owners and man- agers get the upside if the higher-risk loans and investments yield high returns, while the deposit insurer faces the downside if the risky assets fail to pay off The response to this is to regulate banks and force them to hold capital The argument that follows is due to Joshua D Coval, Jakub W Jurek and Erik Stafford (2007), ‘Economic

Catastrophe Bonds’, Harvard Business School Working Paper 07-102, (June).

I made this proposal initially in ‘A Better Way to Organize Securities Markets’, Financial Times, 4 October 2007, and provide more details in ‘Preparing for the Next Financial Crisis’ published initially at

www.eurointelligence.com on 5 November 2007, and reprinted at www.voxeu.com on 18 November 2007.

The subprime series, part 1: Financial crises are not going away 23

28 November 2007

The second essay in this 4-part series discusses the lesson from the Bank of England’s recent experience, arguing that a lender of last resort is no substitute for

a well-designed deposit insurance mechanism.

For decades a debate has been simmering over the advisability of deposit ance One side produces evidence that insuring deposits makes financial crisesmore likely.1These critics of deposit insurance as the first line of defence againstbank panics go on to argue that that the central bank, in its role as lender oflast resort, can stem bank panics Countering this is the view that, as a set of hardand fast rules, deposit insurance is more robust than discretionary central banklending In my view, the September 2007 bank run experienced by the Britishmortgage lender Northern Rock settles this debate once and for all – deposit insur-ance is essential to financial stability

insur-To understand this conclusion, we need to look carefully at experiences withcentral bank extensions of credit – discount lending – and at the varying experi-ence with deposit insurance Let’s start with the lender of last resort

Lender of last resort

In 1873 Walter Bagehot suggested that, in order to prevent the failure of solventbut illiquid financial institutions, the central bank should lend freely on goodcollateral at a penalty rate.2 By lending freely, he meant providing liquidity ondemand to any bank that asked Good collateral would ensure that the borrowingbank was in fact solvent, and a high interest rate would penalize the bank forfailing to manage its assets sufficiently cautiously While such a system could work

to stem financial contagion, it has a critical flaw For Bagehot-style lending towork, central bank officials who approve the loan applications must be able to dis-tinguish an illiquid from an insolvent institution But since there are no operat-

The subprime series, part 2: Deposit insurance and the lender of last resort

2 The original source is Walter Bagehot (1873), Lombard Street: A Description of the Money Market, London: Henry S Kin & Co.

ing financial markets and no prices for financial instruments during times ofcrisis, computing the market value of a bank’s asset is almost impossible Because

a bank will go to the central bank for a direct loan only after exhausting all tunities to sell its assets and borrow from other banks without collateral, the need

oppor-to seek a loan from the government draws its solvency inoppor-to question.3

Deposit insurance

Deposit insurance operates in a way that contrasts sharply with the lender of lastresort A standard system has an explicit deposit limit that protects the bank’sliability holders – usually small depositors – from loss in the event that the bankfails Guarantees are financed by an insurance fund that collects premiums fromthe banks Logic and experience teach us both that insurers have to be national inscope and backed, implicitly if not explicitly, by the national government trea-sury’s taxing authority Funds that are either private or provided by regionalgovernments are simply incapable of credibly guaranteeing the deposits in theentire banking system of a country

But as I suggested at the outset, deposit insurance has its problems We knowthat insurance changes people’s behaviour Protected depositors have no incentive

to monitor their bankers’ behaviour Knowing this, bankers take on more risk thanthey would normally, since they get the benefits while the government assumesthe costs In protecting depositors, then, deposit insurance encourages createsmoral hazard – something it has in common with the lender of last resort

Which is better?

How can we figure out whether the lender of last resort or deposit insurance worksbetter? A physical scientist faced with such a question would run a controlledexperiment, drawing inferences from variation in experimental conditions.Monetary and financial policy-makers cannot do this Imagine a statementannouncing a policy action beginning something like this: ‘Having achieved ourstabilization objectives, we have decided to run an experiment that will help uswith further management of the economic and financial system ’

There is an alternative to irresponsible policy experiments: figuring out whichpolicies are likely to work best requires us to look at the consequences of differ-ences that occur on their own Comparing the mid-September 2007 bank runexperienced by a UK mortgage lender, Northern Rock, with recent events in theUnited States provides us with just such a natural experiment

The US example is typical of how the loss of depositors’ confidence, regardless

of its source, can lead to a run The Abacus Savings Bank serves large numbers ofChinese immigrants in New York, New Jersey and Pennsylvania In April 2003news spread through the Chinese-language media that one of the bank’s New York

26 The First Global Financial Crisis of the 21st Century

3 Another flaw in the Bagehot framework is that banks appear to attach a stigma to discount borrowing For ple, in over one-third of the days between 9 August and 21 November 2007 there were federal funds transactions reported at rates in excess of the discount lending rate In one case, on 25 October 2007 when the lending rate was set at 5.25%, the Federal Reserve Bank of New York reported an intra-day high of 15%.

exam-City managers had embezzled more than $1m Frightened depositors, unfamiliarwith the safeguards in place at US banks, converged on three of the institution’sbranches to withdraw their balances Because Abacus Savings was financiallysound, having recently concluded its annual government examination, it was able

to meet all requested withdrawals during the course of the day In the end, as a USTreasury official observed, the real danger was that depositors might be robbedcarrying large quantities of cash away from the bank Leaving their funds in thebank would have been safer But rumour and a lack of familiarity with govern-ment-sponsored deposit insurance – Federal Deposit Insurance insured everydepositor up to $100,000 – caused depositors to panic.4

Contrast this with the recent UK experience, where deposit insurance covers100% of the first 2,000 and 90% of the next 33,000, and even then payouts cantake months Under these circumstances, the lender of last resort is an importantcomponent of the defence against runs.5

Central banks are extremely wary of taking on any sort of credit risk; in somecases there may be legal prohibitions against it In lending operations, this trans-lates into caution in the determining the acceptability of collateral And here iswhere the problem occurs In order to carry out their responsibility, centralbankers must answer two important questions First, is the borrower solvent?Second, are the assets being brought as collateral of sufficient value?6

The Northern Rock case brings the weaknesses of this system into stark relief.The broad outlines of the case are as follows Northern Rock is a mortgage lenderthat financed its long-term lending with funds raised in short-term money mar-kets When, starting in mid-August 2007, the commercial paper markets cameunder stress, Northern Rock started having trouble issuing sufficient liabilities tosupport the level of assets on its balance sheet

The natural move at this point was to seek funds from the Bank of England Butlending requires that the answer to the two questions about solvency and collateralquality are both yes Were they for Northern Rock? I have no idea Some combi-nation of people in the Bank of England and the UK Financial Services Authoritymay have known, but I wonder Since Northern Rock is rumoured to have hadexposure to American subprime mortgages, securities for which prices were nearlyimpossible to come by, it is no exaggeration to suggest that no one was in a posi-tion to accurately evaluate solvency As for the value of the collateral, again it waslikely very difficult to tell

The subprime series, part 2: Deposit insurance and the lender of last resort 27

4 See James Barron (2003), ‘Chinatown Bank Endures Run as Fear Trumps Reassurances’, New York Times, 23 April.

5 For an exhaustive description of deposit insurance systems in the EU see Robert A Eisenbeis and George G Kaufman (2006), ‘Cross-Border Banking: Challenges for Deposit Insurance and Financial Stability in the European Union’, Federal Reserve Bank of Atlanta Working Paper 2006-15 (October).

6 As an episode 20 years ago demonstrates, the Federal Reserve turns out to have substantial discretion in ing these questions On 20 November 1985, a software error prevented the Bank of New York (BONY) from keeping track of its Treasury bond trades For 90 minutes transactions poured in, and the bank accumulated and paid for US Treasury bonds, notes and bills Importantly, BONY promised to make payments without actually having the funds But when the time came to deliver the securities and collect from the buyers, BONY employ- ees could not tell who the buyers and sellers were, or what quantities and prices they had agreed to – the infor- mation had been erased By the end of the day, BONY had bought and failed to deliver so many securities that it was committed to paying out $23 billion that it did not have The Federal Reserve stepped in and made an overnight loan equal to that amount, taking virtually the entire bank – buildings, furniture and all – as collateral See the discussion in Stephen G Cecchetti (2008), Money, Banking and Financial Markets, 2nd edn, Boston, MA: McGraw-Hill, Irwin.

answer-Problem with last-resort lending

So, here is the problem: discount lending requires discretionary evaluations based

on incomplete information during a crisis Deposit insurance is a set of announced rules The lesson I take away from this is that if you want to stop bankruns – and I think we all do – rules are better

pre-This all leads us to thinking more carefully about how to design deposit ance Here, we have quite a bit of experience As is always the case, the detailsmatter and not all schemes are created equal A successful deposit-insurancesystem – one that insulates a commercial bank’s retail customers from financialcrisis – has a number of essential elements Prime among them is the ability ofsupervisors to close preemptively an institution prior to insolvency This is what,

insur-in the United States, is called ‘prompt corrective action’, and it is part of thedetailed regulatory and supervisory apparatus that must accompany deposit insur-ance

In addition to this, there is a need for quick resolution that leaves depositorsunaffected Furthermore, since deposit insurance is about keeping depositors fromwithdrawing their balances, there must be a mechanism whereby institutions can

be closed in a way that depositors do not notice At its peak, during the clean-up

of the US savings and loan crisis, American authorities were closing depositoryinstitutions at a rate of more than two per working day – and they were doing itwithout any disruption to individuals’ access to their deposit balances

Returning to my conclusion, I will reiterate that this episode makes clear that awell-designed rules-based deposit insurance scheme should be the first step in pro-tecting the banking system from future financial crises

28 The First Global Financial Crisis of the 21st Century

it works we take it for granted; when it does not, watch out But, as we have seenrecently, financial markets and institutions can malfunction at a moment’s notice.

To prevent this, governments regulate and supervise financial institutions andmarkets And best practice dictates that financial stability is one of the primaryobjectives of the central bank

Central banks and financial supervision

For over a decade there has been a debate over how to structure government sight What responsibilities should reside in the central bank? Different countriesresolve this question differently In places like Italy, the Netherlands, Portugal, theUnited States and New Zealand, the central bank supervises banks By contrast, inAustralia, the United Kingdom and Japan, supervision is done by an independentauthority Is one of these organizational arrangements better than the other? Doesone size fit all?

over-The events of the summer and autumn of 2007 shed new light on this question,and my conclusion is that there is now an even stronger argument for placingsupervisory authority inside the central bank As events unfolded through Augustand September, it became increasingly clear that having the bank supervisorsseparated from the liquidity provider placed added stress on the system.1

Subprime series, part 3:

Why central banks should be

Pros and cons of separation

To understand this conclusion let me very briefly summarize the traditional ments for and against separation of the monetary and supervisory authorities.2

argu-Starting with the former, the most compelling rationale for separation is thepotential for conflict of interest The central bank will be hesitant to imposemonetary restraint out of concern for the damage it might do to the banks itsupervises The central bank will protect banks rather than the public interest.Making banks look bad makes supervisors look bad So, allowing banks to failwould affect the central banker/supervisor’s reputation

In this same vein, Goodhart3argues for separation based on the fact that theembarrassment of poor supervisory performance could damage the reputation ofthe central bank Monetary policy-makers who are viewed as incompetent have adifficult time achieving their objectives

Turning to the arguments against separation, there is the general question ofwhether a central bank can deal effectively with threats to financial stability with-out being a supervisor There are a variety of reasons why the answer might be no.First and foremost, as a supervisor, the central bank has expertise in evaluatingconditions in the banking sector, in the payments systems and in capital marketsmore generally During periods when financial stability is threatened, when there

is the threat that problems in one institution will spread, such evaluations must

be done extremely quickly

Importantly, the central bank will be in a position to make informed decisionsabout the tradeoffs among its goals, knowing whether provision of liquidity willjeopardize its macroeconomic stabilization objectives, for example They are inthe best position to evaluate the long-term costs of what may be seen as short-runbailouts Put another way, appropriate actions require that monetary policy-mak-ers and bank supervisors internalize each others’ objectives Separation makes thisdifficult

Second, separation can lead central bankers to ignore the impact of monetarypolicy on banking-system health A simple example of this is the potential for cap-ital requirements to exacerbate business-cycle fluctuations Granted, this seemsunlikely, but regardless, the argument goes as follows: when the economy starts toslow, the quality of bank assets decline This, in turn, reduces the level of capital,increasing leverage Banks respond by cutting back on lending, slowing the econ-omy even further Combatting this requires that monetary policy-makers takeexplicit account of banking-system health when making their decisions And,without adequate supervisory information, there is concern that they might not.Most relevant to the recent experience is the fact that in their day-to-day inter-actions with commercial banks (and other financial institutions) central bankersneed to manage credit risk both in the payments system and in their lending oper-ations In the United States, for example, the Federal Reserve allows banks what

30 The First Global Financial Crisis of the 21st Century

2 For a detailed and very thought-provoking discussion see both the text and the references in Ben S Bernanke,

‘Central banking and Bank Supervision in the United States’, speech delivered at the Allied Social Science Association Annual Meeting, Chicago, Illinois, 5 January 2007.

3 See Charles Goodhart (2000), ‘The Organizational Structure of Banking Supervision’, Occasional Papers, no.1, Basel, Switzerland: Financial Stability Institute (November).